The Fed Did Its Job, Now Washington Needs To Come Through With Fiscal Policy

Don't say he's not trying

Contrary to nearly every headline you read about monetary policy these days, I believe it is quite possible the Fed Chairmen Ben Bernanke is performing quite well and much better than any of his recent predecessors. In fact, I think he is directing monetary policy with unprecedented precision and skill and that the responsibility for the health of the economy now rests squarely on fiscal policy.

Mr. Bernanke’s Fed has done everything it can to balance two conflicting goals: ensuring a speedy economic recovery and maximizing the long-term structural growth rate of our economy. The burden is now on legislators and the White House to get fiscal policy back in shape and remove the black clouds of healthcare and financial reform. It is important to note that the Fed must keep its cards close to its vest whenever it needs to manage expectations, which is most of the time. So, Mr. Bernanke cannot say what I am saying because revealing his strategy and exactly how he expects it to manifest would conflict with the expectations he aims to set. In other words, as long as people believe he is willing to do everything in his power to prop up securities markets and consumer spending, then his plan is working whether or not that is what he is willing to do. My thesis rests on three key points:

1. On the margin and from a global perspective, money is getting tighter not looser.
2. Mr. Bernanke understands the long-term implications of monetary policy decisions on global growth potential.
3. Mr. Bernanke is more economist than narcissist and cares more about making the best decisions for our economy than pleasing the fickle whims of the media and the markets.

First Sign of the End of Loose Money: China’s Decision To Remove the Wen Jiabao Put. Like the “Greenspan put” supporting high expectations for growth in the U.S. around the turn of the century, the Wen Jiabao put represented the expectation that the Chinese government would do whatever it takes to keep GDP growth greater than 8%. Therefore, investors felt comfortable placing bets that relied on and benefited from 8%+ GDP growth in China just as investors felt comfortable piling money into the U.S. housing and capital markets during Greenspan’s tenure. China removed the Wen Jiabao put on October 19, 2010 when China’s Communist Party announced an interest rate hike and signaled a clear shift in policy toward ensuring more rational and deliberate capital allocation. As mentioned above, I believe this announcement is an historic event given the Party’s 15-year track record of maintaining growth-at-all-cost policies. China’s underscored its dedication to the policy change when its central bank announced it will raise bank’s reserve requirement ratio by half a percentage point on November 10.

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Why Remove the Wen Jiabao Put? Benefiting from seeing mistakes of more advanced economies, China’s leadership, in my opinion, is taking pro-active steps to avoid the gross misallocations of capital that result from bubbles in asset prices. By signaling that they will no longer maintain super low rates that enable loose money and encourage the borrow-and-spend mentality required to maintain 8%+ GDP, I believe China’s leadership recognizes that the true growth rate of its economy is lower than 8%. Therefore, artificially spurring growth to higher levels in the short-term only undermines long-term growth potential by wasting capital and resources on low-return activities and projects when it could be allocated to higher return opportunities. In other words, China recognizes the fact that keeping interest rates artificially low does permanent long-term damage to its economy. For more on how keeping rates artificially low harms economies in the long term see my recent article on the subject. As China aims to transition from an export-driven economy to one that maintains better balance with domestic consumption, it is especially important to ensure the prudence of capital allocation.

What Does China’s Shift In Policy Mean for the U.S.? First, I believe that China’s decision to tighten their money supply will also tighten money in the U.S. Higher interest rates in China will divert capital from U.S. securities back to China. Note that China is one of the largest holders of U.S. Treasuries. China’s plans to reduce its current account surplus will likely drive a reduction in our current account deficit. And over time, as the value of China’s and other emerging economies’ currencies continue to rise, the spending subsidy created by the super-cheap goods from China will dissipate. In addition, China’s policy shift toward tighter money puts U.S. politicians and regulators on the clock for following suit or risking major long-term damage to their legacies, in my opinion. As explained in my 4Q09 Letter to Investors, “one benefit of the 24-hour news cycle is that more people know more about global affairs, which forces politicians to be more proactive to ensure their country does not repeat the mistakes of others.” Counter-balancing the pressure from China is the fact that politicians will be vilified for supporting or doing anything that may make the economy worse in the short-term. Unfortunately, our democratic political system makes it very difficult for elected officials to make the best decisions for the long-term if they cause any short-term pain. As detailed in my article: Trust Google Not Government, many politicians and regulators are more focused on getting re-elected or keeping their job than acting in the best long-term interested of their constituents. Their focus is on serving the needs of the present and anything that might not improve their ratings until after their term of office or service is not likely on their radar. In this (albeit narrow) context, one could say that being a Communist country gives China’s political leaders an advantage over U.S. political leaders. They do not have to worry much about getting re-elected. Consequently, they need not be as focused on serving the whims of election cycles and can enact policies that despite causing short-term pain are in the best long-term interests of their country.

The Beginning of the End of Loose Money: Level Of QE2 Stays Steady Despite China’s Tightening. It appears that the Federal Reserve is already on the same page as China given their decision to keep QE2 on the low to middle range of expectations after removal of the Wen Jiabao Put. If the Fed really wanted to boost money supply, it seems it would have had to increase the level of QE2 to offset the tightening created by China. The Fed’s decision is consistent with its strategy to provide credit and financial support in an extraordinarily precise manner. In other words, money has, for the most part, been made loose only to those who have needed it most (e.g. TALF and MMIFF)[1]. Overall money supply growth has been quite tame since the beginning of 2009 because the Fed so accurately delivered the credit to its targeted recipients who quickly (and thankfully) soaked it up. As a result, very little, if any, excess liquidity spilled over into imprudent hands as indicated by the current low inflation and low capacity utilization. QE2 follows the same strategy and is aimed primarily at banks to encourage more lending to small and medium-sized businesses[2]. In addition, the Fed has taken unprecedented action to keep the cost of capital higher and the yield curve flatter by paying banks a small, but significant fee for reserves they deposit at the Fed. This new payment system also takes the cheapest money out of circulation because it encourages banks to leave more funds on deposit at the Fed rather until they identify a more profitable alternative. By keeping the yield curve flat, QE2 pressures banks to make more higher-return loans as investing in treasuries and short-term facilities provides a lower and lower profit margin. The Fed’s strategy is to increase money supply through increased bank lending, which tends to drive growth in business investing which, in turn, creates jobs. Note that this approach to increasing money supply indicates the Fed is focused on ensuring that money is allocated to where it can be productive and earn good returns, assuming, of course, that banks are back in the business of making prudent loans. In addition, QE2, by keeping mortgage rates low, effectively eases the debts of homeowners and helps households survive the low-employment environment. In my opinion, the Fed’s recent announcement sends a clear message to the current political administration: “we have done the best we can do with our monetary policy tools, now it is your turn to get fiscal policy on track.” Not coincidentally, the Fed’s message encores the desire for better fiscal policy communicated by the electorate one day earlier.

What Will The Fed Do Next. I think Mr. Bernanke is quite pleased with the current situation. He wants the markets, despite his actions to the contrary, to think that he is willing to print as much money as needed to keep the economy growing and keep consumer sentiment sanguine about economic prospects. He knows that on the margin positive consumer sentiment is required for economic growth. He is in the business of managing expectations. Accordingly, I think he will continue to lean toward keeping rates and money supply flat while adjusting to changes in the pace of economic recovery. As long as the economy continues to improve steadily, I think the Fed will, albeit very gradually and slowly, lean toward tightening until we see a sustained rebound in job creation. I believe that optimal implementation of monetary policy results in gradual and sometimes imperceptible changes in the economy. The Fed is in the business of smoothing business cycles not amplifying them. It is admirable that Mr. Bernanke’s strategy to-date has not resulted in any sudden or jerky changes in our economy. Going forward, I think the Fed will continue to minimize the amount of excess liquidity in the system to avoid the need for a sudden or large increase in rates that would be required by a sudden, large increase in inflation. My opinions are based on the beliefs that:

• Mr. Bernanke is keenly aware of the steep fall from grace experienced by Mr. Greenspan for keeping rates too low for too long.
• He knows his legacy will most likely be formed over the next several months and that he is smart enough to know that his performance will be measured more by his long-term results than short-term as was the case with Mr. Greenspan.
• As an economist (not a narcissist), he is keenly aware of how keeping interest rates too low for too long undermines the long-term growth potential of an economy- as discussed in Artificially Low Interest Rates Do Permanent Economic Damage.

The $64 zillion Question: What About Fiscal Policy: Will U.S. politicians choose to follow Bernanke’s lead and do what is best for the long-term or will the succumb to the pressures of the short-term? The answer probably lies somewhere in the middle and will rely on the interplay of the following dynamics:

1. The biggest bottleneck for job creation is business pessimism, which is due almost entirely to concerns over taxes, the impact/cost of health care reform and changes in regulation[3].
2. GOP takeover of the House of Representatives signals a strong desire by the electorate for fiscal policy reform and probably means that the President will be forced to practice less partisan politics. It also means that financial regulatory and health care reform will draw lots of scrutiny as that legislation is gradually implemented.
3. The pressure of China’s fiscal and monetary decisions will not abate as the Red State’s economic decision-making will likely continue to favor long-term prosperity over short-term appeasement.
4. A deadlocked Congress could make passing any new legislation quite difficult.
5. The President’s track record to-date has not been very business friendly.

Conclusion. Tighter money means less speculative investing. I believe we are entering an environment more conducive to value investing or, more specifically, an environment where skill in assessing the true economic profitability and valuation of companies will determine the success of stock-pickers. I welcome this change as I believe it means we are returning to a more rational and deliberate capital allocation environment, which will enable the United States to allocate capital more effectively to higher returning opportunities and drive standards of living higher.

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[1] This assertion is partly derived from the illuminating report from GaveKal research: “QE2-The Fifth Phase of the Fed’s Crisis Response”.

[2] Most bank lending to businesses has been to large corporations who have hardly needed it. Many borrowed just to refinance more expensive, pre-existing debt. Banks have remained resistant to adding any risk and have been content to ride the yield curve as the health of their loan portfolios improves.

[3] According to the NFIB’s Small Business: Problems and Priorities report and as highlighted in GaveKal research: “QE2-The Fifth Phase of the Fed’s Crisis Response”..

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